The Bull Bear Trader discusses market events and news with an interest in understanding risk and return in both bull and bear markets. Discussion topics include trading and hedging strategies, derivatives, risk management, hedge funds, quantitative finance, the energy and commodity markets, and private equity, as well as an occasional investment opinion.

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As expected and discussed, Microsoft did raise its offer to $33 a share. Also somewhat to be expected, Yahoo! wanted more money. What was not expected was how Microsoft decided to not go hostile, and simply said see you later, it is time to move on. Given that the current negotiations had gone on too long, and that a hostile bid would have probably destroyed value for each company, I imagine that right now many Microsoft shareholders and employees are cheering. While some Yahoo! employees are also probably happy with their new increased level of job security (for now), and being able to avoid a forced culture clash between the two companies, I am sure that many Yahoo! shareholders are beginning to considering new lawsuits, besides those already in process. To not take a $33 a share price to the shareholders for a vote will certainly get the activists and lawyers interested.

In the end, Ballmer held to his reputation of not messing around, being upfront, and playing tough but fair. He did give a little, but in the end stayed true to his word. A lot of people were talking about how both Microsoft and Steve Ballmer needed this deal, yet he was still not willing to overpay. Walking away may end up being the smartest thing Ballmer did. By sweetening the deal by $5 billion, and also deciding to not go hostile, Ballmer has put Jerry Yang and the Yahoo! board on the defensive. Monday trading should be interesting, as some are already expecting Yahoo! to fall to $20 a share or less. Yahoo! will certainly continue to tout the increased revenue earned from farming-out ad revenue to Google during its recent trial run, but Yahoo! will need to have more to offer current shareholders in order to convince them that value and cash was not left on the table. This may end up being more difficult than negotiating with Microsoft.

Losers: Yahoo!Winners: Google, Time Warner, News Corp., and possibly Microsoft if they play their cards right in the next few months

Expect Microsoft to possibly make a play for AOL or MySpace in due time. Expect Yahoo! to try and generate further relationships with Google. Whether Google continues to cooperate, and to what extent given that Microsoft has walked away, will be interesting to watch.

A lot is being written about Exxon Mobil's Q1 2008 earnings of $10.9 billion, the second largest quarterly profit ever for a U.S. company. What is not receiving as much attention, but more than I expected - at least in the blogs, is how Exxon incurred a tax bill of $9.3 billion. When overall international taxes are consider, the tax figure is even more staggering, and increasing at an alarming rate. Adding in sales and other taxes (countries are defining their own ways to profit from oil), total taxes were closer to $29.3 billion.

Exxon in effect paid $3 in taxes for every $1 of earnings. Even with these numbers, we will continue to hear about how higher taxes, and even windfall profit taxes, are needed for the oil companies. Of course, when you tax something you typically get less of it, which may be the point for some, but certainly not an energy plan. Decreased supply will increase prices at the pump.

As for the stock itself, it was down after missing earnings. The street was expecting earnings per share of $2.14, while Exxon delivered $2.03 per share. While high taxes certainly contributed to Exxon's lower than expected earnings, decreasing crack spreads have hurt refiners and other integrated oil companies, such as Exxon. Oil company margins are also not as large as other industries (such as software), squeezing profit margins when costs, such as taxes and commodities, increase.

Interesting chart over at the Bespoke Investment Group site showing how the 50-day average of the daily percentage spread between high and low crude oil price is near the average of the last ten years. Of course, daily price moves are bigger, and short-term volatility may in fact be higher. The results are interesting nonetheless. It would also be interesting to see a longer chart coving some of the 1970s in inflation adjusted terms.

"Copper Caper: Thieves Nab Art To Sell for Scrap"Sarah McBride - WSJ* Thieves are stealing sculptures that are cast in bronze, of which copper is a main ingredient. Manhole cover, pipes, and wiring are also missing as copper prices approach $4 a pound.

"Corn Ethanol Loses More Support"Siobhan Hughes, Ian Talley, and Anjali Cordeiro - WSJ* Members of Congress and Governors asking that ethanol requirements that were recently mandated be scaled back. Good luck in an election year, but it is a start.

"Turmoil leads to new index for US munis"The Economist* Discussion of how the Fed cuts are doing little to reduce borrowing costs but are contributing to the soaring commodity prices. On the plus side, due to the falling dollar, when you exclude oil, the U.S. current-account deficit has fallen to an eight-year low of 2.4% of GDP. How has the Fed contributed (per the article): 1.) With lower rates, the Fed encouraged speculation in commodities since inventory cost were reduced, 2.) Lower rates fostered a weaker dollar, increasing the price of dollar-denominated commodities.

"Grain Companies' Profits Soar As Global Food Crisis Mounts"David Kesmodel, Lauren Etter, and Aaron O. Patrick - WSJ* The food and agriculture story is not new, but what is interesting is how not only are the food producers feeling the pinch, but some farmers themselves are also starting to get squeezed as they are paying more money for seeds, fertilizer and farm gear. Like the gold rush, it is not always the commodity sellers or the miners, but those selling the pick axes that can still realize profits as commodity prices go higher. Companies such as Monsanto, Potash, Agrium, and Mosaic, etc., are still doing well - although the stocks may react a little differently given their huge run-ups. Is there too much speculation? Of interest: "Total index-fund investment in corn, soybeans, wheat, cattle and hogs has increased to more than $47 billion, up from about $10 billion in 2006..." Money is certainly flowing, and demand is still strong. It will be interesting to see how the stocks hold up.

"Commodities jump, but losses raise concerns of downturn"Stevenson Jacobs - The Associated PressIncreased talk about the potential downturn in commodities. Of interest in the article: "... investors are funneling money out of gold exchange-traded funds, or ETFs, which sell shares backed by gold bullion. The biggest gold ETF in the U.S., streetTRACKS Gold Shares, has shed 83 tons of gold since March, roughly half the amount it acquired during the metal's run-up beginning late last year." Pretty amazing. Gold speculation truly does usually end in tears. Large funds appear to be running towards the exits. Even with increased demand, gold may still suffer loses as speculators get out. On the other hand, demand in food commodities will continue and will help to reverse any recent corrections. People need to eat (and fill up our cars with ethanol - at least until mandates are reduced). Recent corrections in the food commodities may allow these assets to build a base, filter out some speculation, and provide a little more clarity as to direction.

"Prospecting for Junior's Gold"Matt Whittaker - Barrons* Junior miners (no, not young miners, but small mining companies) are becoming attractive, not only because of the flexibility they have in downturns/correction, but because they are takeover targets as the majors look for ways to increase market share and juice profits. Of course, with higher potential return comes higher potential risk, including political risk and an inability to absorb high production cost as efficiently.

Derivatives

"Turmoil leads to new index for US munis"Saskia Scholtes - Financial Times* A new index of derivative products are being developed to protect against defaults in ....... hold your breath ....... the munis. Pretty unbelievable how times have changed. Of course, the problems with the monolines did not help the situation.

"There's triple A and there's triple A"Alphaville - Financial Times* Interesting article showing the effects of both Loss Given Default (LGD) and Probability of Default (PD) or Default Rate (DR). Looking at both, the level of loss is more dire for AAA rated debt, forcing triple A debt to be broken into various junior and senior levels (tranches). Another example of the problems and considerations necessary when considering either mark-to-market or mark-to-model accounting. BTW, read the article comments - highlights how confusing everything is.

Hedge Funds

"Hedge Funds Muck In Down On The Farm"James Mackintosh and Kate Burgess - Financial Times* Many hedge funds are beginning to invest in, and outright buy, farms. The move is being made in an effort to take advantage of rising commodity prices, which most feel are here to stay, at least for a while. A few funds also feel that buying farms and having a window into their operations and will give their traders an edge for having information that comes straight from the horse's mouth, figuratively speaking (but not far off). Are farm ETFs next?

"A New Face of Hedge Funds Isn't Shy"Gregory Zuckerman and Jenny Strasburg - WSJ* Profile of David Einhorn, the 39-year old manager of Greenlight Capital. Kind of seems more like a 9-to-5 job.

"New funds cut fees to counter old losses"Alphaville - Financial Times* Somewhat related to the previous article, hedge funds managers are now waiving fees until they again reach the high water mark. This is unusual only in that it is counter to a recent trend of just closing shop and starting over again. Maybe the legal issues are making some managers nervous.

"Hedge Fund Fees Shrink as U.S. Pensions Make Direct Investments"Katherine Burton - Bloomberg* Hedge fund investors, in particular pensions who have been nervous about investing directly in single hedge fund, are moving away from funds-of-funds. The move essentially allows the pension funds to remove the extra layer of fees. Given that funds-of-funds have mixed results, this may be a smart move.

Quantitative Finance and Financial Engineering

"The new fact of 130/30?"AllAboutAlpha.com blog* 130/30 funds not just about quants, but also being used or considered by fundamentally-managed trading-based funds.

"Cudgle Over the Quants"Megan Barnett - Portfolio.com* Quants and others are being sued as they leave one hedge fund to work at or start another. When big money is involved ......

Trading

"A New Wave of Vilifying Short Sellers"Jenny Anderson - NY Times* As with many bear markets or market downturns, Congress and others start pointing fingers at the shorts. Of interest in the article is the statement: "On the New York Stock Exchange, short selling is running near record levels. Just over 4 percent of all the shares on the Big Board were sold short as of March. That figure, however, excludes many rapid trades made every day. Market makers, for example, often go short to ensure customers’ orders are filled quickly. And most hedge funds take short positions to offset their other bets in the markets. So, in all, short selling probably accounts for a quarter or more of all trading." Yes, and some days selling totals more than buying. Maybe we should get rid of that too. Of course, hedging and market maker activities (at least the legal ones) are not usually what people are worrying about. The problem is the pump-and-dumpers, but as Jim Chanos said: "Show me the evidence."

The Daily Options Report blog recently discussed the current low levels of implied volatility as measured by the VIX. When implied volatility is low, option prices are inexpensive, relatively speaking. For long equity investors, this can create an opportunity to replace current long positions with call options, especially those positions that have recently run up. The replacement strategy allows the investor to remain exposed to the upside potential of the position, while also limiting downside risk.

Of course, the strategy is not without its potential costs. First, any gains in the sold long position will be taxed. The options also have a finite life, so the position cannot remain open as long as you may like with the equity position. There is also always the potential that the stock will remain range bound, thereby draining away the time value of your option - although your stock may have not gained much anyway over the same time frame. Once again, not a perfect strategy, but given the current low implied volatility, the strategy is worth a look. Buying puts can also give you a similar payoff, although your overall return may be different since the protective put ties up more capital as you keep your long position open.

There is an interesting post at the Trader's Narrative blog (click on the post title for the link). It is worth a read. In a nutshell, we currently have a steep yield curve, and what this usually signals is that the economy is about to speed up its growth, that the end of any recession/slowdown is near, and that a major economic expansion is close.

A lot has been written about the cause and effect between the falling dollar and the rising price of crude oil. It is usually assumed that the falling dollar is resulting in the price of crude oil being higher than it should be. This is the position that OPEC has recently stated. As reported in the Economist, Harvard economist Jeff Frankel argues that low real interest rates lead to higher commodity prices such that when real rates fall, commodity producers have more incentive to keep their asset rather than sell. This also gives speculators an incentive to sector shift into commodities.

The correlation between the euro/dollar exchange rate and the price of oil has risen over the last few years, increasing from 1% between 1999 and 2004 to 52% in the past six months. Others argue that the link is also influenced by accounting since if the dollar falls, the dollar priced commodity must rise for its overall price to remain consistent and stable. But commodity prices have increased against other commodities as well.

But is the correlation the other way around? Analysts at Goldman Sachs feel the correlation is in the opposite direction. High crude oil prices drive the dollar down since oil exporters import more from Europe than America, with less of their revenues in dollars. Another possible reason for the correlation is that many emerging economies peg their currency to the dollar, and therefore also have a loose monetary policy. These loose dollars increase domestic demand, thereby putting pressure on all commodities, especially crude oil.

In the end, both effects are related to the dollar and may be having the same result, whether rates are low - thereby driving up dollar dominated prices, or whether lower interest rates are promoting a looser policy - thereby increasing demand.

Microsoft is once again stating that is may go hostile in its bid for Yahoo!. If press reports (and rumors) are correct, Microsoft is considering $33 per share, a value I have long felt was fair, and a value that would get the deal done. Maybe I am wrong, given the personal pride and level of greed that has entered the equation for each company. Major shareholders of Yahoo! are apparently now saying they want a $35-$37 per share offer, essentially twice the value of Yahoo! before the bid. Ah, we can dream.

Ballmer has reacted to recent price levels by saying that he will not pay a dollar more than what the company is worth. This of course sounds good, but also gives him the ability to raise the bid if he feels there is suddenly more value. Unfortunately, we may have reached a point were you have to wonder whether any of this is good for anyone. As discussed before, hostile bids typically have many unintended consequences, most if not all of which are negative. A higher bid would also not be looked upon favorably by many current Microsoft shareholder, all of which have seen the recent momentum in their stock halted, and even depressed, as the Yahoo! takeover attempt has played out.

So should Microsoft drop the hostile bid? Not exactly. Given that Yahoo!, its board, and major shareholders seem to be getting a little greedy, Microsoft may have even more leverage. Going to $33 or $34 a share, above the original $31 offer (that is not exactly $31 anymore), would represent a 10% move above an already attractive offer. If Yahoo! would once again reject a higher offer, Microsoft would then have more reason to go hostile by nominating a new slate of directors, the only real possible option given the poison pill in place at Yahoo!. In the end, Jerry Yang may be out, one way or the other. Either he sells his company to Microsoft, is taken over in a successful hostile bid, or wins the takeover attempt, only to see Microsoft walk away, leaving him and his shareholder holding a victory flag worth half its previous value.

Nonfarm payrolls declined by 20,000 in April, much less than the 70-80K loss that was predicted. February and March numbers were revised down. The unemployment rate surprisingly fell 0.1% to 5%. Average hourly earnings increased $0.01, or 0.1%.

The Fed also released a statement about 15 minutes before the payroll number announcement, somewhat spooking the market. The statement highlighted how it will increase the size of its term auction program and expand currency swaps with the ECB and Swiss National Bank, adding further liquidity to the markets. The increase brings the Term Auction Facility to $150 billion, from $100 billion. The swap line with the ECB increased from $20 billion to $50 billion dollars of available credit for borrowing at European banks. Initially the market assumed this news was implying that the payroll numbers would be weak, but of course, they were not as bad as expected.

Recently at my blog I have discussed how the parsing of the Fed statements has reached near comic proportions. I still believe this. What is more important is what the Fed does, and not necessarily what it says - or more importantly, what we think it says. From the statement on Wednesday, I really have no way to know 100% whether they plan to pause or not, regardless of what the pundits say. Today's action also does not indicate a pause, but does highlight how the Fed realizes that rate cuts are not enough, and that other measures need to be taken to increase liquidity. In this regard, the Fed is spot-on. By working with the ECB to help fix the issues with LIBOR, and increase liquidity, it is possible that ARMs and other rate sensitive instruments may reset at manageable levels, and could even possibly reset favorably for some borrowers. This will be good news for the market and investors, and not just those that are currently upside down in their loans.

As recently reported at CFO.com and elsewhere over the last few months, the subprime crisis exposed some fatal flaws in the market. The first was the assumption that securities could always be sold and converted to cash. Obviously, this was not the case, making the prices of derivatives based on these assets also difficult to value. This of course further exposed the second major flaw - that of companies overlooking and not properly understanding their exposure to downside risk.

Of course, if Allstate, State Farm, or other property and casualty insurance companies can manage their risk, why can't the banks? In general, counterparty risk for financial assets is much different than the risk normally taken and managed by the large liability insurance companies. With securities, risk takers cannot estimate the value of their liabilities with the same ease. With market prices, it is difficult, but not impossible. When the market refuses to give you a bid, it then becomes nearly impossible. For a natural disaster or other liability event, traditional insurance companies can within a short period of time get an estimate of the damage, their exposure, and the cost of any liabilities. For a non-traded asset, or at least one that is not offering a bid given that a credit event has occurred, not only do you fail to determine the size of the loss, but you also do not know the solvency of the counterparty. If you took out insurance with a monoline, or took some type of credit hedge position, then great, but chances are all you did in this environment was just double your counterparty risk.

To make matters worse, any negative event will affect your ability to raise capital, unlike the property insurance companies. When a damaging storm hits, then yes, the insurance companies will take a big hit and end up spending some of their float and capital base, but they can recover it back over the next year as they increase rates to cover past losses and new risk. Credit risk has just the opposite effect. Increased risk lowers your credit rating, making raising new funds just that much more expensive. To add insult to injury, fair-value accounting will require you to take a write-down, even when you are not currently experiencing the impact of a change in credit risk given that you can still hold the asset while you wait for conditions to hopefully improve. These accounting rules cause the market to continue to experience these forced write-downs, even for securities that have not been sold, or may be sold later for less of a loss, or even a gain. But this does not really matter since for this quarter the company is in the tank, or at least we think they are since no real price is available to mark against. To add to the uncertainty, it is difficult to tell how many of these write-downs will be unwound in later quarters, or how much market capitalization has been lost and not put to productive use as companies write-down losses that in some cases are temporary and pulled out of thin air.

Increasing leverage has worded so well over the last few months (tongue firmly in cheek), that it only makes sense to give average individual investors the same opportunity to seek a Fed bailout. Fortunately, roulette players now have a vehicle tailored just for them. Rafferty Asset Management has entered the ETF market, but not in an ordinary way. The firm has registered 34 ETFs based on various market indexes, each of which will deliver 3x the daily return (or inverse for the short ETFs). I am sure John Bogle, the champion of index ETFs, is not amused.

It is worth knowing that the ETFs deliver 2 or 3 times the daily return of the index concerned. Therefore, if the index goes up 1%, you do not necessarily get a 2% or 3% return. The 2x or 3x calculation only works from market open to market close. As such, these ETFs are tailored for daytraders and speculators that trade often during the day. The models could possibly be used for hedging, and would reduce the size of the position, but this does not appear to be the intended audience.

Watching the post-Fed announcement finance shows (both before and after the market close), along with a read of the print media on the Fed's move, brings up a number of observations regarding the recent decision. The most interesting observation is how the market participants and pundits really, and I mean really, wanted a halt in interest rates, now or in the future, along with at least a neutral bias. Of course, the market did not get what it wanted. Or did it?

As the statement was released, every word was parsed to find its hidden meaning, or at least to see what was different from the last statement (more about this is a moment). What may be even more interesting is how all the hand wringing may have just been wasted energy, as the contents of the Fed report almost seemed to not matter. The majority of the pundits immediately talked about how the Fed has signaled a pause, some before they even read a word themselves. Even headlines from the major print media and other publications are using this and similar language - the Fed is pausing.

Below is the exact statement as released by the Fed:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 2-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Atlanta, and San Francisco.

If you are having trouble figuring out what is different from the last meeting, have no fear - you are not alone. To make things easier, the WSJ has done all the heavy lifting for you, creating a parsing graphic - essentially taking the parsing of the statement to comical proportions. Even worse is how the pundits read into the statement what they want. My hope is that unlike the rest of us (myself included), the Fed spends more time worrying about the implications of their moves, and less about how the statement will be interpreted. Given the general nature of the statement, I suspect that this is not the case.

So let me join in the fun, and confusion.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Interpretation: Therefore, we plan to pause. Well, maybe not. In fact, you could argue for just the opposite.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

Interpretation: Inflation is a mixed bag. Core is better, and the committee expects inflation to moderate in coming quarters. Nonetheless, energy and other commodity prices have increased, and there is still uncertainty. So what is the read? Since inflation is not as much of a problem (core), and commodity prices are moving just as they were during recent cutting, we can keep on lowering rates. Therefore, do we plan to pause? Well, again, maybe not. Like before, we could argue that they will stay the course, continuing to cut.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Interpretation: The key for the pundits is the first line. Easing to date is working, has helped to moderate growth, and should continue to do so. Gone from the previous statement is the phrase "downside risk to growth remains." Different to be sure, but is "help to promote moderate growth over time" a big enough change to infer a pause? Some mention that the second line also supports the pause, but isn't this line simply the Fed's mandate? Others supporting the impact of the second line mention how "act as needed" has now replaced "act in a timely manner." Seems a stretch to me. So now, while not timely, the Fed will monitor developments and act as needed, either to increase growth or decrease inflation. Again, isn't this just their mandate?

In the end, the market is hanging on the "substantial easing" paragraph, assuming that a pause is in the cards. This may very well be the case, but I am not sure this is what the Fed is signaling, or intended to signal. Furthermore, I am not even sure this is what the market is now signaling. A Fed pause would imply a stronger dollar, lower commodity prices, lower prices for the related agriculture plays (like the fertilizer companies), and a general market rally. We really got little of this after the announcement on Wednesday. Maybe future market action will give more clarity.

[Update: Clarity - indeed. Nice rally Thursday. Since a number of resistance levels are being tested, the next few days/weeks will be interesting. The strong dollar, and its effects, played out today.]

Of course, maybe we are missing the point entirely. Debating the impact of the statement on the markets may be like debating a lagging indicator - it is what it is. Maybe it makes more sense to talk about how the market action today, and over the next two months, will impact what the Fed does at their next meeting. It is certainly starting to look more and more like the markets move and control the Fed, and not necessarily the other way around. With unclear statements, the Fed may be simply hedging its bets. The current market action may be just a clue for what will drive the next decision. Of course, when that decision is made, and the statement is released to the market, we will once again need to roll out the parsing machine and let the silliness continue.

While seeming to follow, instead of lead, the Fed is contributing to the problem and giving the market the power. Like a spoiled child, the market did not get what it wants, and as a result, is not going to play nice. Trying to convince us that the Fed is done easing, regardless of whether that is actually the case or not, is not going to change the behavior. What the market needs is closure.

The Federal Reserve cut the federal funds rate by 0.25% to 2%. The discount rate that banks charge each other was also lowered 0.25% to 2.25%. There were two dissenters who preferred no cut. The bias was basically unchanged, although the analysts are frantically digging into the report to find some change. Apparently the line about downside risk is gone, or at least the word "downside" is gone, but they still mention how pressures exist and economic activity remains weak, with the markets remaining under considerable stress. Amazing how we find one word that is different and then start speculating on whether the Fed is planning to pause or not. I would not be surprised to see the market analysts begin to spin this as a pause, with the Fed now being neutral.

Still early, but the dollar is relatively flat, commodities are relatively unchanged, and the market is confused. Kind of a letdown, at least for traders. Given that the Fed will not meet for another 8 weeks, they may feel they will essentially be pausing for a few months, at which point they may have more clarity. It may take a while to see the full impact on energy, commodities, and the industrials.

The numbers are out and the market reaction is somewhat expected. The ADP Employment number was higher than expected, coming in at 10K when the market expected -60K. Big miss? Well, yes, but as we have mention before, the ADP number is somewhat unreliable and at times difficult to predict. It has been right on at times, but also so far off that it loses some predictive power. The futures increased slightly on the news, but the "rally" was muted, probably somewhat due to the reliability of the number, somewhat due to other news coming out.

The GDP number showed the economy grew at 0.6% in Q1, matching the 2007 Q4 rate. The market expected 0.5%. Take that Recession! Of course, taking out the exports and trade, the GDP was negative, but this was also expected. Given that there are two more opportunities to revise this number over the next two months, and the little room for movement, a negative Q1 GDP is still possible. Inventories rose $1.8 billion, which was only a slight increase compared to the increase of $30.6 billion in Q3, and the $18.3 decrease in Q4. Certainly not as bad as some expected. The market response, while getting a short bump in futures after the news, was also muted, as with the ADP numbers.

Also of interest in the GDP report is how the PCE price gauge rose 3.5%, with the core at 2.2%. The core number continues to be in range but high enough to give the Fed a reason for pausing. Durable goods purchases fell 6.1%, while non-durable spending was down 1.3%. I am sure these numbers are not a surprise to the automotive companies. Residential fixed investment, i.e. housing, was down 26.7%. Ouch. Exports rose 5.5%, imports up 2.5%. No doubt crude oil contributed to the imports.

The market is at an interesting inflection point. Wednesday gives us a the ADP Employment report, the GDP report, and a Fed rate decision. In the mean time, there is a move into tech from dollar related equities and commodities, such as the agriculture plays, energy plays, and large cap internationals (that may see a wash for any Fed cut - dollar move). Finance and market geeks love this kind of stuff, even though the hours and even days before can get kind of boring as the market waits for the Fed news. Given that GDP and an employment report are also coming out beforehand, and that the market has been doing some sector rotation in advance of the Fed decision, things have at least been a little more interesting, and somewhat of a preview of what is to come.

Up first will be the ADP Employment number, which while sometimes predictive of the Friday jobs number, has also been a somewhat unreliable indicator. The market is expecting a -60,000 loss.

Next will be the advanced GDP report for Q1. The market is expecting a 0.5% value for GDP. Given that is number can be "inflated" a little, it will be important to dig into the details. Since recessions are defined by two negative quarters of GDP, there is certainly interest in having a positive GDP, even if small. It is not that the number will be faked, but high inventories in particular can cause the number to look better than it actually is. High inventories affect the calculation by raising the number, but as any business knows, excess inventories is not usually good. Not only do they cost more to insure and store, but just because an inventory item is complete and ready to sell does not mean it will translate to accounts receivable anytime soon while it sits on the shelf. Economist, and the market, will be watching the inventory levels.

Later in the afternoon we will get the Federal Reserve decision. The Fed Fund Futures are pricing in a near certain chance the Fed will cut by 25 bps. Anything more would certainly not send a good signal. No cut, and probably even a 25 bp cut with a tightening bias would be bullish for the dollar, and subsequently negative for those stocks and commodities that have benefited from the lower dollar - such as agriculture plays, energy plays, and large-cap industrials with large international exposure.

Of additional interest in the Fed announcement will be the number of dissenting votes, if any. The money market futures are already pricing in rate hikes next year, so chances are there may be some dissent if we get a cut, as with the last few meetings. What may bring everyone to the table in agreement is a change in bias - allowing the Fed to further highlight that the tide has changed.

As already mention, the market is anticipating an end to the rate easing cycle. Combined with the recent Barron's article discussing how the dollar may have finally hit bottom, traders have already begun to cycle out of commodities, which have run-up considerably since the beginning of the year, and into select technology stocks that have recently reported good earnings and/or have given good guidance.

Put options on the USO crude oil ETF have also been increasing, with 2/3rds on the short side, while the DUG Ultrashort oil ETF has seen triple normal volume. While a long shot, recent chatter in Washington about the problems caused by Ethanol could cause the bottom to fall out further for the soft ag commodities, although that may be expecting too much in an election year. Commodity related stocks, such as Deere have sold off, while the fertilizer companies, such as Mosaic, Potash, and Agrium are also correcting after recent parabolic moves. Nonetheless, downward moves might be short lived if demand for grains continue to increase, regardless of Fed decisions and dollar moves. Crude oil and natural gas will also see demand and supply pressures, with crude seeing some of the dollar premium taken out as the Fed begins to tighten, or imply an end to easing. Of course contrarians may be smiling, given how the increased short positions in oil could go badly for the longs if the market does not get what it wants.

It looks like the Microsoft takeover attempt of Yahoo! has finally reach a point were it may in fact start destroying value for both companies. But then again, most mergers usually end up doing just that, so maybe they are just more efficient. Given the move in Yahoo! stock today, it appears that the market thinks a merger is still possible. Word on the street is that the $33 a share number is being thrown around again. Even though I originally felt somewhere in the $31-$35 range was likely, with $33-$35 being what was needed to get the deal done, I figured that was not possible anymore after Yahoo!'s less than stellar Q1 earnings.

Having said that, maybe Microsoft would be smart to pony-up and get the deal done before any more damage is done. Already today I have heard some analysts talking about how extra time will just result in further complications. One such complication is a common technique used by the takeover candidate for fending off the hostile bid - you simply begin worrying in public about the potential anti-trust problems with the merger. Of course, when a deal does get done (assuming it gets done), this will surly be brought up when regulators look at the deal. Another complication with waiting is the patience of the existing shareholders. At this point it is unclear exactly how many original shareholders are left, and how many shares are simply in the hands of the arbs, each of which will certainly expect to get paid. To make matters worse, it appears that many employees inside Microsoft are not excited about the possibility of a Yahoo! merger, not to mention the Yahoo! employees, many who have probably shed some of their shares, at least the shares they control and can sell without offending the higher-ups. Beyond potential job losses, integration of the two different (quiet different) corporate cultures is going to be difficult, to say the least. The number of these like-minded employees, on both sides, that decide to leave the companies will certainly continue to grow.

For some extra insight, Paul Kedrosky at the Infectious Greed blog also has some interesting and funny things to say about the potential merger, along with a link to a detailed analysis of any hostile takeover attempt. Potentially messy indeed.

It looks like Citigroup is going to compensate clients that incurred losses at its Falcon and ASTA/MAT hedge funds. Both were fixed-income funds that were hit by the recent credit crunch, with Falcon falling 75% in value and ASTA/MAT falling more than 90% in value. Before credit problems, each fund generated significant returns, with the help of leverage, of course.

Under the compromise, the wealth-management unit will absorb $250 million to allow investors in the Falcon fund to exit without incurring total loss if they agree to forfeit all legal claims against the funds and Citigroup. It is expected that some ASTA/MAT investors will get a similar offer. Of interest is how the story mentions that "some" will get a similar offer. Given that all investments are risky, and that even in a "conservative" fixed income fund there are going to be losses, Citigroup certainly sees this as an opportunity to retain some clients. Others don't agree and feel that Citigroup is worried about getting sued. If Citigroup did push the fund as a "safe" fixed-income investment, like investing in CDs, then some investors may have a case. This may also influence how they determine who gets compensation and how much. As reported in the WSJ, some feel the bank did in fact set the compensation at a level that was "just enough so they don't sue us." Nonetheless, given that there was a debate inside Citigroup about whether to even compensate these investors, I suspect is was less about getting sued, and more about keeping large clients.

Update: To add insult to injury, Citi just reported that it will sell at least $3 billion in common stock to strengthen its capital base. This comes after it recently sold $6 billion in preferred stock just a few weeks ago. The company has already raised over $36 billion in new capital through preferred stock and sovereign wealth fund investments, in part to cover $35 billions in write-downs on CMOs and bad LBO debt, among others. Maybe the hedge fund losses and disgruntled investors are still the least of their problems.

A rumor at the Apple tuaw.com weblog is describing how Apple is working on a new iPhone application called iControl, allowing the iPhone to connect wirelessly to local iTunes libraries and then play stored media. Again, this is just a rumor, but it does drive home a difference between Apple and other smart phones - Apple has a unique ability to integrate the iPhone with its own existing media sources, such as iTunes, and various software applications, like Safari. Is iChat for the iPhone next? Who knows, but it does bring up an interesting observation. Does Research In Motion have the functionality and applications that will drive demand forward, or is design, email ease, and past loyalty enough?

Recently, RIMM reported that it added 6.5 million subscribers in its last fiscal year, twice the previous number, and more than Apple. The stock has also been responding well recently as it nears a 52 week high, partly on the introduction of the Pearl and Curve, each of which has been helping RIMM capture more of the consumer market, in addition to its corporate Blackberry market. Nonetheless, RIMM is still losing some share (albeit in a growing market, thank you Apple), with market share in the U.S. down 5% to 40%. Apple has taken over / created a 17% share in just its first 6 months, and this number is expected to grow. By working with Microsoft, iPhones will also be able to work with business computers, allowing Apple to go beyond the consumer market where it has growing share, and further tap into the corporate market, currently dominated by RIMM's Blackberry customer base. A faster 3G phone that is expected to be launched in June should increase Apple sales, although RIMM is also releasing a new 3G phone in May. But the question remains. With headwinds from Apple and other Smartphones, can RIMM continue to dominate, or will RIMM possibly become the next TIVO?

As we often forget, Tivo revolutionized an industry, created one really, with the introduction of the DVR - digital video recorder. The problem was that Tivo really did not have a product that could not easily be reproduced, nor did it have a killer app. It is true that TIVO has TivoToGo, allowing you to download videos to your computer or other mobile device, and does allow for on-line scheduling, but are these enough? I personally own a few Tivos and enjoy the convenience of on-line scheduling, and do occasionally download a show for my laptop if going on a trip, but I don't find the features something that makes me want to go out and buy a new machine. In fact, in addition to Tivos in the house, I also have a few cable supplied DVRs. Personally, I still find the Tivo easier to operate, but it does not matter. The cable DVR is convenient and cost effective, given that I don't have to buy it, I can record HD shows, and the monthly service charge is just about the same. Sure, Tivo now has a HD DRV, but it is still expensive, and even with a lower cost, what is the motivation for making the purchase?

This brings us back to Apple and RIMM. Why do I buy a Blackberry or other new smartphone from RIMM over the Apple iPhone? Does one or the other have a killer app? Recently, two software developers for RIMM discussed how a touch-screen Blackberry is in development, and how it will be an Apple Killer. But will this killer app be an Apple killer, or just a way to try and keep up? If current crack-berry addicts prefer the tactile keyboard for their email, what will motivate them to buy the touch-screen version? If the non-corporate consumer market wants a touch-screen, why not just buy an iPhone?

So in the end, what will be the motivation for consumers? If you believe the major media CEOs and analysts, content is what is important. On this front, Apple again has an advantage. Beyond its iTunes library, Apple has released programming tools for developers, driving expectations of increased offerings of entertainment programs that should be available for the iPhone later in the year. This is further strengthen by the connection the iPhone has with the iMac computers, where iMac computers are driving sales of iPhones, and iPhone are driving sales of iMacs. If it is true that "content is king," then RIMM may become the next Tivo, and Apple with its extended supporting product line and applications should continue to see success. RIMM will not go away, just as Tivo still tries to innovate today. Both Apple and RIMM may continue to see growth and higher stock prices in the near-term, but eventually RIMM may find itself with continued shrinking share and less ability to differentiate itself. In the end, or at least-longer term, this may begin to affect valuation. Only new innovation, content, and/or the devotion of the crack-berry addicts, may continue to drive market share.

Warren Buffett was smiling this morning on CNBC while announcing his role (and that of Berkshire Hathaway) in helping Mars Inc. buy Wrigley. Berkshire will be contributing about $6.5 billion to help with the acquisition. What does Buffett get in return? The $6.5 billion consist of $4.4 billion of subordinated debt to help Mars pay for the acquisition, along with a $2.1 billion equity stake in Mars after the deal closes, with the shares being bought at a discount. Just another version of the "golden rule" - those with the gold make the rules. On the other hand, a nice premium is being paid for Wrigley, something that Buffett usually tries to avoid, although he has paid-up a few times to get a strong name. At least here he is getting a discount on the premium (if that makes sense).

Of course, everything may not be as sugar coated as the company's products. A combined Mars - Wrigley will control a large segment of the confectionery market, creating a "global powerhouse" to use the WSJs words. It will be interesting to see if this becomes an anti-trust concern. After all, regulators do not have anything else to work on right now, so making sure the chocolate and sugar markets are not being cornered should be a priority.

Finally, the real story may have been the fact that Goldman Sachs was willing to step up to the plate and fund the merger to the tune of $5.7 billion. Not a big risk or huge numbers for Goldman (interesting how $5.7 billion is not considered huge anymore), but certainly big enough to show up on the financial statements. Personally, I kind of miss Merger Mondays. It always starts the week off with a little momentum. Not sure this is the blockbuster that will break the trend, given that Berkshire was needed to co-sign the loan, but it is a start.

As I was browsing various blog sites I came across an article entitled "What is High Implied Volatility?" at the VIX And More blog. The article is worth a read, and is linked above, but I wanted to mention and elaborate on a simple concept from the article that often gets overlooked. As traders and professors we often instruct students and others about how we can compare implied volatility to historical volatility to see whether an option is over-price or under-priced, assuming that the historical volatility is constant, and that it will stay that way into the future. Of course, comparing the two in real-life without such assumptions can be a little more complex.

As described at VIX and More, we need to compare the current implied volatility with a defined range of either historical volatility or implied volatility. Of importance are the time frames used, the type of past volatility (historical or implied), and the comparison universe (the same stock and/or similar stocks). Furthermore - and this is the key - we must not forget that historical volatility is by definition, and calculation, backward looking. On the other hand, implied volatility is forward looking and considers the market's expectation and potential reaction to news and events, such as earnings, dividends, FDA phase testing results, Federal Reserve actions, etc.

To make life easier, sometimes a relative measure, even one that considers a range or moving average, is useful. For those with a little more background and interests in mathematics and modeling, one of the many variations of the Generalized Autoregressive Conditionally Heteroskedastic (GARCH) models, or stochastic models of implied volatility surfaces, can be used. Other models also exist. I have used GARCH and find it to be useful when constructing option spreads, although parameter selection is necessary. With the right software, even a pre-programed Excel spreadsheet, the analysis can be implemented with less pain than expected, and sometimes incorporated into defined trading rules for those platforms that allow such integration.

I often get asked about subprime, Colateralized Debt Obligations - CDO, Collageralized Mortgage Obligations - CMO, Credit Default Swaps - CDS, and that odd thing called a tranche by people other than my students - who already had to endue my lectures on the subject. Therefore, I figured it was worth putting together something for the blog, outside of what I normally teach. Hopefully I can find the time to develop and post a series of tutorials this summer, but in the mean time the following short segment from CNBC's PowerLunch is a good start regarding subprime and the creation of mortgage-backed derivatives (such as CMOs).

There are other explanations (videos and Powerpoints) that are more entertaining and a little less tasteful at times (and also sometimes better at explaining the subject), but I will take the high road for now and let you find those on your own. A few longer presentations that are more informative, but also a little dryer, also exist.

Barron's has an interesting article this weekend about whether the dollar is ready to rally - something that has recently been discussed quiet often in various television and print media outlets. Of interest from the article:

"In an April survey conducted by Merrill Lynch, 50% of global money managers said the greenback is undervalued, up from 30% three months ago, while a whopping 71% found the euro overvalued."

"Our own "Big Money" poll of nearly 120 money managers ... found most waiting for a massive unwinding of the recent short-dollar, long-commodity crush: Nearly three-quarters say they expect the dollar to rise against the euro over the next 12 months, while 66% see commodity prices falling in the next six months."

The article also mentions how reserve managers are unwilling to sell dollars at their current low levels, hinting that many feel we may be approaching a bottom, or at least at levels that they don't want to get caught selling at the low.

If the dollar does rally against the Euro and other currencies, investors can expect to see an effect on the price of oil and other commodities. Some estimates have 50% or more of the recent moves in oil, which is denominated in dollars, being currency driven. With any fall in crude oil, we may also expect to see some effect on metals/minerals and agriculture commodities. Agriculture commodities have inadvertently been linked to energy prices, along with the fertilizer companies which have benefited from their growth. Large multi-national industrial companies, which have benefited from selling cheaper products overseas, may also be impacted. Of course, there are always caveats. Regardless of currency moves, demand for both energy and commodities is still expected to stay strong. The large industrials, which will benefit from lower energy and commodity prices, will also see some tangential benefits that may help to offset currency moves.